Forget the GNP, bankers watch the credit cycle.

While many Americans gauge the health of the economy by watching for quarterly changes in the gross national product, bankers keep an eye on a different measure: the credit cycle.

The credit cycle improves as banks are able to put aside smaller and smaller provisions against possible losses on bad loans. In essence, it's a sign of bankers' optimism about their loan portfolios.

In recent quarters, the credit cycle has been doing nothing but getting worse, as banks gird for losses on real estate loans and other credits.

While there are some indications that the credit cycle has gotten as bad as it will get, improvement - when it comes - will probably be slow.

Indeed, for the remainder of this year and a goodly part of the next, expert say, a substantial portion of the industry will be more focused on building reserve ratios than on building loan portfolios.

"This is going to make the recovery more difficult and prolonged," said William Wallace, the former first vice president of the Federal Reserve Bank of Dallas who is business dean at Old Dominion College, Norfolk.

Provisions Rise 21%

The severity of the problem showed in the banking industry's first-quarter loss provision of $7.1 billion, up 21% from the same period of 1990. Unencumbered, that capital could have supported more than $100 billion of new loans.

And even after bearing that penalty, U.S. banks still lost ground: To maintain the 71% ratio of loss reserves to problem loans recorded at yearend, a provision not of $7.1 billion but of $12.7 billion was needed. The $5.6 billion difference represents the entirety of the banking industry's first-quarter earnings.

In the face of mounting loan defaults and chargeoffs, therefore, the only way many banks can show profits is by letting their reserve position slip. "This is not an encouraging sign for the industry," said Frank Anderson, a senior analyst with Stephens Inc., Little Rock, Ark.

Loan Defaults Continue

One force compelling continued high loss provisions is ongoing loan defaults, particularly in the Northeast and to lesser extents in the Southeast and the West. During the first quarter alone, these regions largely accounted for a $7.3 billion increase in problem loans in the U.S. banking industry, according to the Federal Deposit Insurance Corp.

And severe problems in highly leveraged transactions and real estate portfolios are still on the rise, said the FDIC. During the first quarter, the portion of bank realty credits in default climbed to 7.36% from 6.59%. At the end of the period, 9.8% of the banking industry's $74 billion of HLT loans were in default.

"The data provide no evidence that a turnaround in bank credit quality is at hand," said Kenneth Puglisi, a senior vice president at Keefe, Bruyette & Woods Inc.

Having no way to examine bank portfolios themselves, investors in turn are arbitrarily establishing reserve ratio minimums, which will sustain pressure for larger provisions necessary to maintain or boost reserve positions.

This is a bit unfair, in that loans properly written down at the time of default arguably do not need the backing of substantial loss reserves, said Mr. Puglisi. But the reality, said Mr. Anderson, is that investors "have shown no interest in banks having reserve ratios of less than 70%."

Further pressure for higher loss provisions will come from bank regulators, said Jerry Jordan, chief economist with First Interstate Bancorp, Los Angeles.

Mr. Jordan said high equity and reserve ratios are seen as the only cushions insulating the FDIC and taxpayers from bank losses. Lower reserve positions won't be permitted until the industry achieves a much greater degree of portfolio diversification, he said.

To be sure, a number of major banking companies are emerging with revived lending where-withal even as the problems of the overall industry appear to deepen.

Mr. Puglisi of Keefe Bruyette noted that many midwestern banks, for example, appear to have seen the worst of their portfolio deterioration and are turning their attention back to the lending market.

Portfolio Diversification

But even among these companies, the very process of portfolio diversification will slow lending during the recovery, said Barry Sullivan, chairman and chief executive of First Chicago Corp. The executive explained that bankers will be seeking to offset risky credits already on the books with highly conservative new loans.

In practice, Mr. Sullivan said, this means virtually no new lending to the troubled realty and HLT markets for a period of years.

And in the interim, he said, midsize and small companies will have a tougher time getting bank financing. "That type of loan will require much more capital from the borrower than what we have seen historically," he said.

From an economic perspective, that means the banking industry at large is not in a position to provide the lending leadership traditionally expected of it in an economic recovery.

To the extent the recovery hinges on this leadership, said Robert Dugger, chief economist for the American Bankers Association, it will proceed at only half the speed expected of a normal upturn.

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